The Best, and Worst, Preferred Stock Funds

Not yet familiar with preferred shares? With “common” shares paying so little, it’s time to get acquainted.

You can double your yields, and actually reduce your risk, by trading in your common shares for preferreds. I’ll explain how – and will also warn you about an overlooked pitfall you should avoid.

Most investors only consider “common” shares of stock when they look for income. These are the shares in a company you receive when you place an order with your broker.

Problem is, most dividend darlings don’t pay much on their common shares today. You’ll be hard pressed to find a dividend aristocrat with a yield above 3% or a P/E ratio below 20 – evaporating business models or not!

A Bear Market in Common Yields

A company will issue preferred shares to raise capital. In return it will pay regular dividends on these shares – and as their name suggests, preferreds do receive their payouts before common shares. They typically get paid more, and even have a priority claim on the company’s earnings and assets in case something bad happens, like bankruptcy.

So far so good. The tradeoff? Less upside. But in today’s expensive stock market, it may not be a bad trade to make. Let’s walk through a couple transactions that would roughly double your current dividends with a simple trade-in.

Wells Fargo’s (WFC) common shares pay a respectable 3% today. But it recently issued shares of preferred stock paying 5.5% – almost double. If you’re looking for income, and you like Wells Fargo too, then the preferreds are a compelling play.

A million bucks in WFC common shares will only net you $30,000 today annually. That’s not even $15 an hour – there are coffee baristas down the block who make more! But the preferred option will land you a more respectable $55,000 per year passive gig.

Similarly common shares of JPMorgan (JPM) – which I like and own warrants on – pay 2.9%. Not bad, but you could more than double your yield by buying JPM’s “Series Y” preferred stock offering for 6.1% annually.

Series what? That’s a big problem with preferred shares – they are often complicated to purchase without the help of a human broker.

Which tempts many investors to streamline their online buys and simply purchase ETFs like the PowerShares Preferred Portfolio (PGX) and the iShares S&P U.S. Preferred Stock Index Fund (PFF). After all these funds pay 5.6% each and, in theory, they diversify your credit risk.

And if we include the brick wall the financial world ran into ten years ago, these funds haven’t even performed to their current yields:

The Problem With Financial Brick Walls

I suspect PGX and PFF probably won’t actually return 5.6% annually over the next decade, either. Which why I recommend moving past a broad-based ETF in favor of a fund with an active manager working for you. There’s extra yield to be had in preferred shares – but you should make sure you have an expert buying your stock to keep you safe and on the road.

Earlier this year, investors irrationally sold any and all closed-ends down to silly bargain prices. Some deservedly so, but these two high quality preferred funds – with excellent management teams and track records – were swept away by the hysteria.

That’s great for us. Low prices mean higher yields plus some upside as these funds gradually close their discount windows. And these 7.6% and 7.7% yields net us 27% more income, and do so more securely, than their ETF counterparts. Plus, these funds have a history of actually delivering these types of returns over the long haul (unlike the more popular ETFs).

Lesser-known high income plays like these are the cornerstones of my “no withdrawal” retirement portfolio strategy. Why rely on stock price appreciation in an inflated market when there are secure, high paying dividends you can simply live off of and keep your capital intact?

Most investors know this is the right approach to retirement. Problem is, they don’tknow how to find 7% and 8% yields to fund their lives.